Mechanics of Futures Markets

41

Forward contracts differ from futures contracts in a number of ways. Forward

contracts are private arrangements between two parties, whereas futures contracts are
traded on exchanges. There is generally a single delivery date in a forward contract,
whereas futures contracts frequently involve a range of such dates. Because they are not
traded on exchanges, forward contracts do not need to be standardized. A forward
contract is not 1:1sually settled until the end of its life, and most contracts do in fact lead
to delivery of the underlying asset or a cash settlement at this time.
In the next few chapters we shall examine in more detail the ways in which forward
and futures contracts can be used for hedging. We shall also look at how forward and
futures prices are determined.

FURTHER READING
Gastineau, G. L., D. J. Smith, and R. Todd. Risk Management, Derivatives, and Financial
Analysis under SFAS No. 133. The Research Foundation of AIMR and Blackwell Series in
Finance, 200 1.
Jones, F. J., and R. J. Teweles. In: The Futures Game, edited by B. Warwick, 3rd edn. New Ycirk:
McGraw-Hill, 1998.
Jorion, P. "Risk Management Lessons from Long-Tenn Capital Management," European
Financial Management, 6, 3 (September 2000): 277-300.
Kawall~r, I. G., and P. D. Koch. "Meeting the Highly Effective Expectation Criterion for Hedge
Accounting," Journal of Derivatives, 1, 4 (Summer 2000): 79-87.
Lowenstein, R. When Genius Failed: The Rise and Fall of Long-Term Capital Management. New
York: Random House, 2000.

Questions and Problems (Answers in Solutions Manual)

2.1. Distinguish between the terms open interest and trading volume.
2.2. What is the difference between a local and a commission broker?
2.3. Suppose that you enter into a short futures contract to sell July silver for $10.20 per ounce
on the New York Commodity Exchange. The size of the contract is 5,000 ounces. The
initial margin is $4,000, and the maintenance margin is $3,000. What change in the
futures price will lead to a margin caii? What happens if you do not meet the margin caii?
2.4. Suppose that in September 2009 a company takes a long position in a contract on May
2010 crude oil futures. It closes out its position in March 2010. The futures price (per
barrel) is $68.30 when it enters into the contract, $70.50 when it closes out its position,
and $69.10 at the end of December 2009. One contract is for the delivery of 1,000 barrels.
What is the company's total profit? When is it realized? How is it taxed if it is (a) a hedger
and (b) a speculator? Assume that the company has a December 31 year-end.
2.5. What does a stop order to sell at $2 mean? When might it be used? What does a limit
order .to sell at $2 mean? When might it be used?
2.6. What is the difference between the operation of .the margin accounts administered by a
clearinghouse and those administered by a broker?
2.7. What differences exist in the way prices are quoted in the foreign exchange futures
market, the foreign exchange spot market, and the foreign exchange forward market?

42

CHAPTER 2

2.8. The party with a short position in a futures contract sometimes has options as to the
precise asset that will be delivered, where delivery will take place, when delivery will take
place, and so on. Do these options increase or decrease the futures price? Explain your
reasoning.
2.9. What are the most important aspects of the design of a new futures contract?
2.1 0. Explain how margins protect investors against the possibility of default.
2.11. A trader buys two July futures contracts on orange juice. Each contract is for the delivery
of 15,000 pounds. The current futures price is 160 cents per pound; the-initial margin is
$6,000 per contract, and the maintenance margin is $4,500 per contract. What price
change would lead to a margin call? Under what circumstances could $2,000 be withdrawn from the margin account?
2.12. Show that, if the futures price of a commodity is greater than the spot price during the
delivery period, then there is an arbitrage opportunity. Does an arbitrage opportunity
exist if the futures price is less than the spot price? Explain your answer.
2.13. Explain the difference between a market-if-touched order and a stop order.
2:14. Expl;;tin what a stotrlimit order to sell at 20.30 with a limit of 20.10 means.
2.15. At the end of one day a clearinghouse member is long 100 contracts, and the settlement
price is $50,000 per contract. The original margin is $2,000 per contract. On the following
day the member becomes responsible for clearing an additional20 long contracts, entered
into at a price of $51,000 per contract. The settlement price at the end of this day is
$50,200. How much does the member have to add to its margin account with the
exchange clearinghouse?
2.16. On July 1, 2009, a Japanese company enters into a forward contract to buy $1 million on
January 1, 2010. On September 1, 2009, it enters into a forward contract to sell $1 million
on January 1, 2010. Describe the profit or loss the company will make in yen as a function
of the forward exchange rates on July I, 2009, and September 1, 2009.
2.17. The forward price of the Swiss franc for delivery in 45 da:ys is quoted as 1.2500. The
futures price for a contract that will be delivered in 45 days is 0.7980. Explain these two
quotes. Which is more favorable_ for an investor wanting to sell Swiss francs?
2.18. Suppose you call your broker and issue instructions to sell one July hogs contract.
Describe what happens.
2.19. "Speculation in futures markets is pure gambling. It is not in the public interest to allow
speculators to trade on a futures exchange." Discuss this viewpoint.
2.20. Identify the comn;wdities whose futures contracts
Table 2.2.

hav~

the highest open interest in

2.21. What do you think would happen if an exchange started trading a contract in which the
quality of the underlying asset was incompletely specified?
2.22. "When a futures contract is traded on the floor of the exchange, it may be the case that the
open interest increases by one, stays the same, or decreases by one." Explain this statement.
2.23. Suppose that, on October 24, 2009, a company sells one April 2010 live cattle futures
contract. It closes out its position on January 21, 2010. The futures price (per pound) is
91.20 cents when it enters into the contract, 88.30 cents when it closes out its position,
and 88.80 cents at the end of December 2009. One contract is for the delivery of 40,000

Mechanics of Futures Markets

43

pounds of cattle. What is the total profit? How is it taxed if the company is (a) a hedger
and (b) a speculator? Assume that the company has a December 31 year-end.
2.24. A cattle farmer expects to have 120,000 pounds of live cattle to sell in 3 months. The live
cattle futures contract on the Chicago Mercantile Exchange is for the delivery of 40,000
pounds of cattle. How can the farmer use the contract for hedging? From the farmer's
viewpoint, what are the pros and cons of hedging?
2.25. It is July 2008. A mining company has just discovered a small deposit of gold. It will take
6 months to construct the mine. The gold will then be extracted on a more or less
continuous basis for 1 year. Futures contracts on gold are available on the New York
Commodity Exchange. There are delivery months every 2 months from August 2008 to
December 2009. Each contract is for the delivery of 100 ounces. Discuss how the mining
company might use futures markets for hedging.

Assignment Questions
2.26. A company enters into a short futures contract to sell 5,000 bushels of wheat for 450 cents
per bushel. The initial margin is $3,000 and the maintenance margin is $2,000. What price
change would lead to a margin call? Under what circumstances could $1,500 be withdrawn from the margin account?
2.27. Suppose that there are no storage costs for crude oil and the interest rate for borrowing or
lending is 5% per annum. How could you make money on January 8, 2007, by trading
June 2007 and December 2007 contracts? Use Table 2.2.
2.28. What position is equivalent to a long forward contract to buy an asset at K on a certain
date and a put option to sell it for K on that date.
2.29. The author's Web page (www.rotman.utoronto.ca/"'hull/data) contains daily closing
prices for crude oil and gold futures contracts. (Both contracts are traded on NYMEX.)
You are required to download the data and answer the following:
(a) How high do the maintenance margin levels for oil and gold have to be set so that
there is a 1% chance that an investor with a balance slightly above the maintenance
margin level on a particular day has a negative balance 2 days later? How high do
they have to be for a 0.1% chance? Assume daily price changes are normally
distributed with mean zero. Explain why NYMEX might be interested in this
calculation.
(b) Imagine an investor who starts with a long position in the oil contract at the
beginning of the period covered by the data and keeps the contract for the whole
of the period of time covered by the data. Margin balances in excess of the initial
margin are withdrawn. Use the maintenance margin you calculated in part (a) for a
1% risk level and assume that the maintenance margin is 75% of the initial margin.
Calculate the number of margin calls and the number of times the investor has a
negative margin balance. Assume that all margin calls are met in your calculations.
Repeat the calculations for an investor who starts with a short position in the gold
contract.